CWS Market Review – December 10, 2010

Before I get into the meat of today’s update, I have a special announcement: I’ll be unveiling the Buy List for 2011 one week from today-December 17, 2010.

As usual, there will be 20 stocks, and as usual, I’m only making five changes to the list. The new list will go into effect at the beginning of the year. According to the rules of my Buy List, once the new Buy List is set, I can’t make any changes for the entire year.

My goal is to show investors that a disciplined strategy focused on high-quality stocks can consistently beat the market. This will be the fourth year in a row that we’ve beaten the S&P 500.

I announce the Buy List early (usually around the middle of December) so no one can say that I’m using tricks to boost my results.

Now let’s get to the latest news on Wall Street. The S&P 500 closed at yet another 26-month high on Thursday. The index is now up to 1,233.00. Only a few days ago, the index fell below its 50-day moving average. I guess the bear saw its shadow and quickly returned to hibernating. This has been a great run over the last 21 months, and I think the market still has room to run. The problem, however, is that future gains will be much harder to come by.

As I mentioned last week, the key aspect that’s driving the market is that investors are shifting from low-risk assets to higher-risk assets. This is very important and all investors need to understand this key fact.

During the financial crisis, investors rushed to any super-safe security, completely abandoning everything else. It’s as if everyone on a sinking ship stormed just one lifeboat. As a result, we’re now seeing some very unusual prices.

I’ll give you an example: The Wall Street Journal recently noted that U.S. nonfinancial companies are sitting on close to $2 trillion in cash. That’s 7.4% of their assets which is the highest level in 50 years. Companies are nearly terrified to put their money to work. This $2 trillion number is also inflated because a lot of that money is held overseas and to bring it back to the United States would incur taxes.

Consider that investors are currently willing to lend their money to the U.S. Treasury for five years in return for just 1.9% per year. That’s crazy, and what’s even crazier is that the yield is up about 70 basis points in the last month. In contrast to U.S. government debt, Reynolds American ($RAI) currently yields more than three times what the 5-year Treasury yields. Or, look at Nicholas Financial ($NICK) which is selling for well below 10 times earnings. Sure, I understand that safety is valuable, but these prices just don’t make sense.

So now we’re seeing this madness slowly unwind. My take is that the Fed’s recent policies are aiding this risk shift. For example, mirroring the stock market rally, long-term Treasuries continue to sell off which means that their yields rise. On Wednesday, the yield on the 30-year Treasury broke 4.5%, the highest yield in over six months.

In other words, the trend is out of bonds and into stocks (especially cyclicals), and our Buy List has done especially well. For the year, our Buy List is up 13.38% through Thursday. Let’s look at some news impacting our stocks.

I was happy to see that Leucadia National ($LUK) broke out to a two-year high on Thursday. Earlier this week, Leucadia announced that it’s restoring its 25-cent annual dividend after not having paid a dividend since 2007. That’s a nice vote of confidence.

Speaking of dividends, Stryker ($SYK) announced a 20% increase in its quarterly dividend. The dividend will rise from 15 cents per share to 18 cents per share. The new dividend will be paid on January 31 to shareholders of record as of December 31.

I really like Stryker. The odd thing is that the stock has been a sluggish performer since the spring. (A lot of good health care stocks have been slow to move.) Nevertheless, Stryker had a very good earnings report in October and they raised the low-end of this year’s EPS forecast. They now see 2010 earnings coming in between $3.27 per share and $3.30 per share. Last year, they earned $2.95 per share which is pretty decent growth in a weak economy.

I’m also happy to see that shares of AFLAC ($AFL) have recovered. In the last few e-letters, I reminded you that AFL was looking cheap. The stock got as high as $56.23 on Thursday before settling back to $55.62. I have no idea how this stock could have dropped below $51 a few days ago, but it did.

As I’ve said before, I think AFL will soon make a run at $60. The company should make about $6.20 per share next year. If AFL went for the same earnings multiple as the rest of the market, it would be an $81 stock.

We also saw a new 52-week high for Becton, Dickinson ($BDX) earlier this week (please note: This was incorrectly labeled as Black & Decker in the email). This is interesting because BDX was our only Buy List stock to fall short of its Wall Street earnings estimate during the last reporting season. They missed by just a penny, but it was still a decent earnings report.

Some Buy List stocks that look especially good here (in addition to the ones mentioned above) include Wright Express ($WXS), Gilead Sciences ($GILD) and Bed Bath & Beyond ($BBBY).

There are two news items to look forward to next week. On Tuesday, the Federal Reserve meets. I don’t expect them to take any action, but it will be interesting to see if the language in their post-meeting policy statements hints at any changes in their thinking. The recent surge in cyclical stocks leads me to believe that a rate hike will come sooner than most folks on Wall Street expect. I suspect that there might be some growing dissention within the FOMC.

On Wednesday, the Fed will release the November report on industrial production. The last industrial production report appeared a bit tepid, but the details showed that manufacturing production increased in October. Manufacturing production was also revised higher for both August and September.

This helps explain why, through this past Tuesday, the Morgan Stanley Cyclical Index had outperformed the S&P 500 for nine-straight sessions, for 13 of the last 14 and for 21 of the last 25. The equation is the same: movement out of low risk and into higher-risk.

That’s all for now. I’ll have more market analysis for you in the next issue of CWS Market Review!

Posted by on December 10th, 2010 at 9:29 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.